Seeking Funding for your Start-up? Watch Out for Misalignment

You’re launching a start-up, and you need capital. But depending on the size of your ambitions, your plans for the funds you intend to raise, and the long-term direction you’d like to take your company after your launch, you’ll need a comprehensive and well thought out funding strategy. You may prefer to keep your investors limited and your company small and lean, or you may be looking for VCs or institutional funding. But your chosen source matters, and it matters more than you may realize at the start.

Relying on the wrong kind of capital or turning to the wrong source for support can actually derail your venture before you even get off the ground, and the most common funding problem is one that start-up entrepreneurs often recognize too late: misalignment. Misalignment means that the shared incentives and risks between you and your investors are not structured properly.

Here’s a quick summary of various types of funding approaches and some ways to avoid misalignment:

Friends and family rounds: It’s very common for startups to first raise money through “friends and family.” Typically, these types of rounds use convertible notes or SAFEs as the funding instrument. When doing a friends and family round, we recommend only work with friends and family who have significant experience and sophistication with investments in early stage companies. It’s tempting to want anyone with available capital--your best friend from university, your sister, your great aunt Gladys--to fund your venture, but this is an unwise idea for several reasons. Securities rules will vary by state but the less sophisticated your friends and family, the more likely you will need robust disclosures to remain compliant with securities rules. In general, friends and family investors will be the most “hands-off” of your investors, which means you will retain significant control even after the round is completed.

Angel investors: Angels are a common next step after friends and family for many founders. Angel investors usually provide anywhere from six to seven figures in investment, and while it’s not unheard of for angels to want a board seat, they generally tend to be hands off as well. The nice thing about working with angel investors is they are typically far more sophisticated than friends and family. Find an angel investor who has domain and subject matter expertise about your industry, who is well connected, and views the investment in your company and the relationship with you as a long term endeavor. Avoid angel investors who appear to make shotgun-style type of investments without a cohesive investment strategy, who don’t have good advisors for themselves, and who seek too much early stage control.

Venture capital investment: Institutional money usually comes in at your Series A or Series B raise, when you’re seeking to raise in excess of $1 million. Working with VCs brings several competitive advantages to an early stage company: financial support, a network of other portfolio companies, well-tested advisors, and access to potential customers and suppliers through VC channels. But it’s important to find the right partner. VCs will typically want board rights and some measure of veto power and control over the business direction of the company. Some (but not all) VCs will insist on the ability to terminate the founders and take control of the company if they are not happy. Investigate and ascertain whether the controls and rights being given to your VC partner are consistent with a shared vision, and if you need to consider giving VCs potential termination rights over you and other founders, make sure you are absolutely comfortable with this type of scenario taking place. It happens more than you think (most such disputes are behind closed doors -- but they happen).

Retail/Consumer Crowdfunding: Retail or consumer crowdfunding is very popular these days and should be considered by every early stage venture. Retail crowdfunding involves a company doing a raise through a crowdfunding portal. The company promises goods or services depending on the amount of money provided by a purchaser.

This type of crowdfunding should always be looked at. In contrast to traditional financing mechanisms, no equity or other obligations (other than sales obligations) are being incurred by the company raising the money. So it is possible to raise significant capital as a type of “advance” being provided by your customers, and then you use the money to develop products and provide them back once they are completed.

There are a lot of success stories of companies using this type of crowdfunding, but also many many horror stories, with founders seemingly taking millions of dollars from their customers and disappearing. If you are serious about doing this type of crowdfunding, there are several controls you should put in place to ensure legitimacy in the marketplace and to protect against consumer backlash and lawsuits in the event the product fails to launch.

Equity crowdfunding: Equity crowdfunding is now available to companies who want to raise money from either accredited investor or from the general public. There are a number of equity crowdfunding portals that help companies structure the sale of securities through crowdfunding. In our experience, equity crowdfunding should be thoroughly thought through as an investment approach. Angels and VC firms have different thoughts about equity crowdfunding, and it may be tough to find a good partner for future private financing once a company has crossed the bridge into some of the equity crowdfunding portals, particularly in doing a public offering.